Does Starbucks Have More Room To Fall?

Summary

Shares of Starbucks slipped by 3% since the beginning of the year.

The company's annual guidance didn't impress its investors.

Does Starbucks' current valuation offer a buying opportunity?

Starbucks (NASDAQ:SBUX) released its earnings report for the first quarter of the fiscal year of 2016. Although the headline EPS figure of $0.46 was slightly higher than the market consensus (by one cent), the 2016 outlook didn't impress investors as the company projects the EPS to rise by 18% to 20%, year over year. Given these estimates and the current market sentiment, does the current valuation measure offer a buying opportunity?

2016 outlook

Based on the market's reaction following the release of the last quarterly earnings report, investors and analysts weren't too impressed by the numbers the company presented for its 2016 guidance.

SBUX reported an estimated non-GAAP earnings per share of $0.38-$0.39 in Q2 FY 2016 or a growth of 15% to 18%, year on year. And for the 2016 fiscal year, the median annual non-GAAP earnings per share is projected to reach $1.88, which is 19% higher than in FY2015.

And given the current market conditions, the company may face additional selloffs in the near term. After all, the major region that expanded the fastest in the past year was Asia - mostly China and Japan: As of the last quarter, 885 stores were opened year over year, which are more than the number of stores opened in the Americas and EMEA combined. And the growth in sales wasn't only due to new stores but also because of improved same-stores sales, as indicated in the following table.

Source: Starbucks

But given the current concerns over the developments in China, will it impact SBUX? So far, these concerns seem to have had a modest adverse impact on Starbucks' stock as it fell by less than 3% since the beginning of the year.

But if China's economy progresses at a slower pace, this could hinder the growth in sales for SBUX in this country. And if the PBOC moves forward and devalues the RMB against the USD, this could also result in having an adverse impact on Starbucks' sales due to currency fluctuations.

China officials are aware of the problems the country faces - including capital flight, growing debt, low investments just to name a few - and may address them. If they move forward and shift the economy's growth towards consumption and less investment, this could actually put more coin into people's pockets - a development that could, over the coming years, boost Starbucks' sales. But if they maintain the same strategy of emphasizing on growth via investments and higher debt, this could keep investors worried over China's outlook, which may weigh on SBUX's stock.

But even though Asia has taken a larger stake in the company's total revenue, it still accounts for only 10%-12% of total sales. Therefore, most of the growth in sales will still likely to come from the Americas - mostly the U.S. (as was the case in 2015). And given the appreciation of the U.S. dollar over the past year, this may have been another advantage for Starbucks over its peers: It is well less exposed to currency fluctuations. So even if the U.S. dollar continues to strengthen, this is likely to have a smaller impact on SBUX than it has on companies with larger stake outside of the U.S. such asMcDonald's (NYSE:MCD).

And in the U.S., sales may keep rising as long as the economy is doing well. For now, the latest reports showed a mixed view of where the economy is heading: Consumer spending and retail sales rose at a slower pace in recent months, while wages and employment picked up at a steady pace. So it's unclear what's next for the U.S.

Despite the latest developments, the market still places a high valuation on SBUX relative to other leading brands, as you can see herein.

Source: Yahoo Finance and Damodaran's site

The higher valuation that SBUX has over other brands and the industry average is due to the higher expected growth in sales, and lower debt burden. The latter also means that debt isn't holding SBUX back from keeping extending its reach to new locations and that interest payments weigh less on its cash flow relative to McDonald's or Yum! Brands (NYSE:YUM).

But if we take a closer look at the forward P/E under certain assumptions (beta: 0.8; expected growth rate over next five years - 20% and afterwards 8%; dividend payout ratio of 40% in first 5 years and then 60%; risk-free rate of 2%; required rate of return of 13%), then it comes out around 20. If the growth rate over the next five years were to drop from 20% per annum to 15%, then the P/E should come down by 4%. And if the risk-free rate (10-year Treasury bonds) climbs by 0.5 percentage point, then the P/E may drop by 10%. The chart below shows changes in P/E over different risk-free rates and growth rate over the next five years.

Source: Author's calculation

Moreover, in order to bring the P/E to around 30, the company's growth in sales after the next five years will have to be around 9%-10% (all other assumptions left unchanged). This isn't a farfetched assumption, but given the global economy's direction - mainly China - and the possible slowdown in the U.S., this could be harder to achieve.

This simplistic calculation was brought to show that the current valuation of SBUX could be a bit high and has some more room to fall before it becomes attractive enough to offer a buying opportunity. And if the bearish market sentiment persists, we could see a further correction for SBUX in the near term. For more please consider: Why Coffee Prices aren't affecting Starbucks?

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may buy shares of SBUX if the stock falls to $53